5 Open Questions on Qualified Opportunity Zones

6 Minute Read

Investors considering opportunity zone funds should be aware of important unresolved issues surrounding both community impact and investment returns.1

Qualified opportunity zones are making headlines. Created by the Tax Cuts & Jobs Act of 2017, the program offers tax incentives to investors who allocate capital to over 8,700 areas designated as opportunity zones. The policy goal is sustained economic development and community benefit to distressed areas. But as funds and investors make progress on execution, important questions surrounding community impact and investment returns remain.

The IRS recently held public hearings on its proposed opportunity zone regulations. In light of the hearings, this piece highlights five investment, tax and community issues worth consideration for those interested in opportunity zone investments.

Community Benefits are being called into question

The opportunity zones program is designed to encourage economic growth, but investors must be thoughtful about the impact of their capital. Recently, three notable issues have presented themselves.

First, there is concern that distressed rural areas will not attract as much capital as their urban counterparts, with which investors may be more familiar. Second, some commentators have asked the IRS to use its regulatory authority to promote diversity, such as by requiring opportunity zone funds’ boards and investment committees to have racial and gender diversity. Third, there have been calls for housing mitigation. For example, there could be a requirement that opportunity zone funds dedicate a certain percentage of their capital to affordable or rent controlled housing.

It is unclear whether the IRS has the authority to enact rules about these issues. However, community impact is at the heart of the opportunity zones program and should not be ignored.

BOTTOM LINE

Opportunity zone investments affect real people in real communities, and investors must weigh whether their activity will have a positive impact.

Similarly, there are questions awaiting resolution by the IRS surrounding fund-level investment. For example, opportunity zone rules seem to envision tax benefits for investors who sell their interest in the fund. But what happens when the fund itself sells businesses or properties? There remains a wide range of open questions, including the following:

Can an opportunity zone sell assets? If it turns out that opportunity zone funds are not able to sell assets, it will greatly impact the value of the investment: Buyers often prefer to buy assets from an entity and will likely demand a discount if they must buy interests in the entity itself. Conversely, if the IRS confirms that opportunity zone funds can sell assets and reinvest the sale proceeds, it could facilitate liquidity.

Do partnership tax rules apply? It is not clear whether familiar partnership tax rules apply if an opportunity zone fund is structured as a partnership for federal tax purposes. For instance, in the event that the fund sells a building, such regulations could materially impact the partners’ tax basis in the fund.

What happens if everyone exits at once? Regardless of how an exit is structured, investors must consider exit risk. It is conceivable, for instance, that investors may look to exit simultaneously around the 10 year mark, after they have met the holding period that allows them to optimize their tax benefits. If many opportunity zone assets come to market concurrently, asset prices could be depressed.

Bottom Line

It remains to be seen whether the IRS will allow opportunity zone funds to sell assets. If asset sales are prohibited, it could be more difficult to maximize value on exit.

Tax Benefits of an Opportunity Zone Fund May Not Survive the Death of the Original Owner

One of the most important questions when it comes to opportunity zones and wealth planning is a basic one: What happens if you die owning an opportunity zone fund? Generally, property that you own at death receives a basis adjustment. Relatives who inherit appreciated stock from you, for instance, receive a tax benefit because their basis is the appreciated stock price. It is unclear, though, how an opportunity zone fund investment will be treated at death.

Bottom Line

An opportunity zone investment can defer, and even partially eliminate, the federal tax that you would otherwise owe on capital gains. But for the vast majority of property, you can eliminate tax on the imbedded gain simply by holding the property until you die. It is uncertain whether the tax benefits of an opportunity zone fund will survive the death of the original owner, so it pays to consider the long-term future consequences of an opportunity zone investment today. Holding existing assets until death may be a better tax strategy.

Proposed Regulations for Investing in Operating Businesses Are Stringent

Congress wants opportunity zone funds to invest not only in real estate inside the designated communities, but also in the equity of those communities’ operating businesses. There is concern, though, that because the definition of a qualifying business is so stringent, businesses inside the zones will find it difficult to attract capital from investors.

Opportunity zone funds must hold at least 90 percent of their assets in qualified opportunity zone property, such as an opportunity zone business. And proposed regulations currently specify that for each taxable year, at least 50 percent of the gross income of a qualified opportunity zone business must be derived from the active conduct of a trade or business in the opportunity zone. But what about a manufacturer in the zone that sells products nationwide? Or a homebuilder who gets his start inside a zone and later finds success building outside of it as well? Under the proposed regulations, it is not clear that opportunity zone funds could invest in these businesses.

Bottom Line

If you are interested in investing in community operating businesses through an opportunity zone fund, wait for clarification from the IRS.

Investors in Opportunity Zone Property Must Be Prepared to Meet “Original Use” or “Substantial Improvement” Qualifications

For those interested in real estate investments in opportunity zones, an important qualification to be aware of is that the “original use” of the real estate inside the zone must begin with the opportunity zone fund. Or, alternatively, the fund must “substantially improve” the property.

What constitutes original use and substantial improvement? The IRS has not issued comprehensive guidance on original use, but the test could be hard to meet. Raw land, we know, does not qualify. But it is unclear if, for example, the fund would get credit for being the original user of a building that has been abandoned for a year or more.

Substantial improvement may be easier to meet. The rule is that during any 30 month period beginning after the date the fund acquires the property, the fund must make improvements that more than double its tax basis in the property. Fortunately for opportunity zone funds, the value of any land associated with the property does not count toward the test.

Guidance by the IRS is needed to illuminate a range of concerns regarding substantial improvement, including whether grace periods will be granted in the event of issues such as construction delays or natural disasters.

Bottom Line

If you want to renovate opportunity zone real estate, be aware that you have a strict 30 month construction window.

Conclusion

Opportunity zones are generating media buzz, and opportunity zone funds are attracting capital. But unanswered questions remain. We are hopeful that the IRS will provide necessary guidance in coming months. That said, it is important to keep the larger picture in mind. The opportunity zone program was designed to have positive community impacts, and it is that objective that should remain central.

This is a changing area and monitoring guidance is recommended. All persons interested in qualified opportunity funds should confer with their legal and tax advisors regarding their particular circumstances.

This information is not intended to be and should not be treated as legal, investment, accounting or tax advice and is for informational purposes only. Readers, including professionals, should under no circumstances rely upon this information as a substitute for their own research or for obtaining specific legal, accounting or tax advice from their own counsel. All information discussed herein is current only as of the date appearing in this material and is subject to change at any time without notice.

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This information is not intended to be and should not be treated as legal, investment, accounting or tax advice and is for informational purposes only. Readers, including professionals, should under no circumstances rely upon this information as a substitute for their own research or for obtaining specific legal, accounting or tax advice from their own counsel. All information discussed herein is current only as of the date appearing in this material and is subject to change at any time without notice.

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